Each morning, I write a 420-word memo because writing is one of the best way to focus your thinking & effect some change you desire. It is a physicalized version of what is going on inside your mental environment.
Missed Monday morning’s memo, so I wrote it on Tuesday. This new habit is a work in progress, but it's important to get 420 posted every day.
While I was studying Credit Risk & Credit Derivatives for the CAIA, all I could think about was the fact that CDOs and CMOs are significantly higher-risk investments than what the risk & valuation methods can ever indicate. I’m fleshing out a theory that this is due to a misunderstanding of what can and cannot be diversified away in a portfolio. Risk can be diversified in some cases, but certainly not others.
I remain highly skeptical of these lacking measures of risk, and the risk-return relationship inherent within these Structured Products, especially in the wake of the ’08-’09 crisis, where they were arguably a principal cause.
The point is not to jump to conclusions and assign blame; is to investigate whether a principal misunderstanding of the risk-return relationship is negatively impacting our ability—as individuals and as a collective market—to obtain an accurate understanding of how money works…
Risk Measures & The Risk-Reward Relationship
The fact is, credit-related risk produces payment distributions that are “substantially skewed to the left. In other words, the upside performance of a traditional position exposed to credit risk is limited to the recovery of the original investment plus the promised yield, whereas the downside performance could lead to the loss of the entire investment” (775).
In the case of credit defaults, there is no partial risk, because there is no partial default. Default either happens or it doesn’t, so the investment either produces a moderate return or it is lost entirely.
How can an investment with that risk profile, and that equally disturbing risk-return profile, be considered an institutional-grade investment?
Meanwhile, the risk profile we associate with Bitcoin (which is based mainly on price volatility, and then perhaps uncertainty regarding regulatory oversight) is considered to be unacceptable for institutions.
These Structured Obligation Products were created by banks as a way to get assets off their balance sheets and then turn around and sell to investors to generate revenue. I see this as an inherent conflict of interest. The ’08-’09 housing crisis is used as an example for many things, and I’m trying to investigate it fully before jumping to conclusions.
It seems banks were caught red-handed, a bail-out was deemed necessary, and conflicts of interest within the system were not addressed. The CFA and CAIA does not seem to have revised & updated their Professional Standards & Ethics policies to accommodate a defense of the profession in the wake of systematic fraud… but maybe these accreditations agencies are not where change will be made.
Much more study to be undertaken…